Description

CF Industrial Holdings, the largest nitrogen fertilizer producer in North America, has been written up six times previously on VIC, most recently three years ago this month.

It also happens to be the largest position in Greenblatt’s GVLU daily rebalanced ETF, which was referred to in a March podcast as representing a portfolio that has historically produced +63% two-year returns (approximately 28% IRR) from its then valuation. More on that immediately below.

This is meant to be an overview and update to a story that is going to be quite familiar to many investors here, but for those unfamiliar, there is plenty to catch the eye. CF was valued at a 19.9% free cash flow yield in its 5/2^nd Q1 earnings presentation (16.5% as stated, but when including the impact of $491M of a Canada/US tax matter that the company has filed amended returns to recover, it should adjust to 19.9%). The stock is down 5% since that earnings report, so it hasn’t exactly run away from this valuation.

This 20% FCF yield, significant production margin advantages versus European and Asian producers given the forward energy spreads in North America, and a strong capital allocation history that combines strategic initiatives with stock repurchasing seems a compelling starting point.

Importantly, unlike other FCF stories, this company carries very little net debt and has been accumulating a significant amount of cash ($2.3B current cash on hand) while they were completing a recent acquisition. More on that later.

First, though, back to why CF was chosen for this writeup. CF Industries Holdings is the largest position in the Joel Greenblatt managed daily rebalanced ETF Gotham 1000 Value ETF, symbol: GVLU.

During an Investors’ Chronicle podcast interview on 3/14/2023, Joel Greenblatt made some interesting comments about the prospective return profiles of the stock market. The key elements are bolded below in this section that begins around the 7:34 mark and continues to 10:54:

https://youtu.be/uUfjIQOlOR4?t=454

For instance we have a strategy that always tries to reweight the portfolio daily towards the cheapest 20% of our universe and let's say it's say the 1400 largest stocks in the U.S.

If that's our universe we're always trying to re-weight the portfolio towards the 20% cheapest based on trailing free cash flows the way that we define it relative to what we're paying. So how much free cash flow are we getting relative to the price we're paying.

We have a portfolio that always re-weights it towards the cheapest 20% and then we can go back over the last 30 years or so and say “Where are we today for that bucket of companies, you know that cheapest 20% relative to the last 30 years?”

And when I looked this morning, we were in the 94th percentile towards cheap for the bucket that we could create today for that portfolio—that theoretical portfolio, and that means there's a lot of companies that at least based on trailing earnings we can buy at very good free cash flow yields.

And the market's only been cheaper for creating that bucket six percent of the time over the last 30 years. And then you can say “Hey what's happened from the 94th percentile in the past?” and the answer to that is… what happens in the past from this valuation level the answer is +63% over the next two years for that bucket of companies that's constantly updated. So pretty good opportunity set for that section of the market.

We can do the same analysis for the SP 500 and that's quite a bit different. Still positive, but the SPs but that's in roughly the 27th percentile towards expensive over the last 30 years. Two year forward returns are closer to about 17%—not 63% but 17% percent. For the SP 500 that's subnormal returns for the last 30 years but not negative. But not the nearly the opportunity set presented by the cheapest section. So it's a real  dichotomy in opportunity sets and that's why it's important to look at individual stocks. As I said a market of stocks not a stock market…

…Our definition of value is cash flow oriented, not low price book [or] low price sales type definition, and we actually view these as companies that you value and try to buy at a discount—that's our definition of value investing.

And giving a cash flow oriented view, there are some really great opportunity sets. And this type of investing, well it's actually done fine. It hasn't way outperformed the SP over the last dozen years or so, but the opportunity set you know I feel the rubber band has stretched for this section of the market to such a degree that the next you know two-three-four years should give it a big advantage and that's the way it's setting up right now for me.

The daily rebalanced ETF that he's talking about is GVLU and there is additional information on the Gotham home page.

For additional perspective, using the 3/13^th closing prices, GVLU has rallied from $18.28 to $19.32 (today 6/8/2023) for a gain of 5.7%.

The SP500 (using ticker SPY) has rallied from $385.36 to $429.13 during the same period for a gain of 11.4%.

BTW, if CF doesn’t interest you, there have been VIC write-ups (with the most recent write up linked provided below) for nine of the top dozen holdings in GVLU:

You could piece together your own GVLU write-up from there.

Now back to CF Industrial Holdings:

The current share price of $67.36 represents a $13.1B market cap, 8.9x NTM forward P/E (4.5x LTM trailing P/E), and 5.5x NTM EV/EBITDA (2.8x trailing), and a 2.4% dividend yield.

CF’s capital structure includes $3.25B of debt offset with $2.8B of cash for an Enterprise Value of $13.6B. During the previous 12 months, they repurchased 6.2% of their shares. The company has a historical record of combined share repurchases with capacity growth such that on a per-share basis, participation in CF’s nitrogen volumes has grown at a 10.% CAGR since 2009.

As VIC contributor afgtt2008 points out in their 2020 write-up, CF has two structural advantages: “a feedstock advantage and a transportation advantage”. Given that the US is a net importer of approximately 1/7^th of its annual consumption of urea, CF benefits from marginal price levels being set by international production while retaining the advantageous low cost of North American natural gas.

As an aside, one of the challenges of VIC is trying to add anything beyond updates to ideas that have already been eloquently explained before. I’m not one to pretend that I’d bet on my insights over those of afgtt2008, or in previous writeups, what was shared by Biffins (CF writeup 4/30/2019), blmsvalue (CF writeup 2/27/2016), rookie964 (CF writeup 10/31/2014 and also on 6/17/2010), and ruby831 (CF writeup 9/19/2005).

Those six write-ups represent 63 pages of summaries and comment threads that might prove to be a fun input for a little side project of an AI bot for CF, but I’d rather not construct something like that without permissions of the authors and the VIC powers-that-be.

In a nutshell, here are some key takeaways from these fifteen years of VIC writeups:

• China has previously had an outsized effect on the world price of urea, but given its dependence on thermal coal and shift away from using energy to support an industry in which it has no real advantages and significant disadvantages, concerns about cheap Chinese competition has declined over time.
• While CF does have an advantage with lower North American feedstock pricing, some of the impact from annual natural gas price fluctuations is mitigated by long-term contracts. [Update: currently CF regularly applies winter hedges to avoid severe weather based disruptions in natural gas prices.]
• Demand for Nitrogen fertilizer is fairly consistent due to it needing to be applied every year given that it is depleted via each harvest cycle.
• The writeup by ruby831 provides some interesting historical perspective. CF was founded as a cooperative and owned by its customers, who in turn were agricultural cooperatives. Thus their IPO had many characteristics similar to a demutualization. It appears that the stock is up 19x since then.

Turning to more recent developments, here are highlights from the last two earnings calls (Q4 on 2/16/23 and Q1 on 5/2/23):

• “Alongside these growth investments, we expect to continue returning substantial capital to shareholders. In 2022, we returned nearly 60% of our free cash flow, $1.65 billion to shareholders through share repurchases and dividends. And in the last 2 years, we have reduced our outstanding share count by 11%. We expect to further leverage the $3 billion share repurchase program recently authorized by the Board to continue building on this track record and providing our long-term shareholders with ever-increasing participation in our business.” [Q4]
• The combination of Russia’s invasion of Ukraine, the large realignment of trade flows, and very high natural gas prices in Europe and Asia combined to push global nitrogen prices to all-time highs in the spring of 2022.
• The response from many agricultural buyers was to use a just-in-time approach to purchasing until prices weakened. CF began seeing more normalized purchasing behavior in February of this year as NOLA urea prices fell from $700 to $300 over the previous five months.
• CF expects industry fundamentals to “fundamentals continue to point to a tight global nitrogen supply and demand balance.”
• Regarding the $500M annual Canadian tax bill and the related amended returns (all related to transfer pricing tax issues) in which CF has filed amended returns for payments made from 2006 to 2011 seeking refunds from the US: “…we should begin to see initial payments probably in the 12 to 18 months with, I would say, full resolution of this anywhere from 36 to 48 months depending on when both jurisdictions get to this item.”
• While there is nothing building going forward related to this tax issue, it did continue through 2021. CF expects to get it all back via US refunds: “the other thing is we did go ahead and make estimated payments for the period of 2012 through 2021 in order to stop the interest ticking as Chris said, the Canada charges a much higher interest rate than the U.S. And so that's where some of the frictional cost comes from. But our expectation is that we'll get much of the money back. And again, the '06 through '11 money faster, the rest of it is going to likely have to go back to another round of arbitration when you're talking about '12 through '21. But we're obviously going to put all efforts forward to recover as much of this as possible.”

Also in that Q4 call in February, CF management made a good summary of the change in Chinese policy and why they continue to expect Chinese urea exports to be down on a year-over-year basis:

“I'd say the biggest thing that affects it is really one of the shift of policy around trying to reduce environmental pollution in the country. There's -- recently here since COVID there's also been a strong desire in order to help curve inflation around availability and affordability of nitrogen fertilizers and so some pretty significant restrictions on exports. But in terms of in a looser export restriction environment, the thing that gives us a lot of comfort around them not going back to sort of the old days is the real push around environmental cleanup and just environmental quality. Urea is a huge particulate matter amid or a big consumer of freshwater, there's not that many employment jobs that go along with it, and you're effectively exporting energy in the form of urea when you're turning around an importing natural gas and it's just not a good trade from a policy perspective but from the central government.”

On top of that, the Chinese market price is currently higher than the global market, eliminating any incentive to export their tonnage.

And during the Q1 earnings call on 5/2/2023:

• “While last year's unprecedented pricing environment has moderated, global industry dynamics remain favorable. Global nitrogen demand that was priced out of the market last year is returning driven by the need to replenish grain stocks. At the same time, forward price curves suggest that energy spreads between North America and high-cost producers in Europe and Asia will continue to be significantly wider than historical averages. As a result, we expect to continue to generate substantial free cash flow.” [Q1]
• “We expect this to be an active fertilizer season -- application season in 2023 with corn acres in the U.S. expected to be up about 5% and wheat acres up around 9% compared to 2022.”
• “Income at the farm gate in the United States and Canada is historically high, underpinned by an extended period of low grain stock-to-use ratios supporting high crop prices, as you can see on Slide 9. We continue to believe that this will take 2 growing seasons at trend yields to replenish global grain stocks. This should support agricultural-led demand as growers seek to optimize nitrogen applications and maximize returns. That said, over the next 7 to 8 weeks, the entire value chain will be walking a logistics tight rope due to the purchasing delays.”
• Regarding the impact of ESG initiatives:
  • What we saw back in 2012 was something like 26 or 27 announced new projects in North America, of which only 4 of them got built, 2 of them by us, 2 other ones, and all of them were built by traditional industry participants. So a lot of the speculative plants that were talked about never materialized. And I would expect that same dynamic to happen here. But I think it's an excellent question, one of those things that we are evaluating and thinking about. And one of the things that I'm also excited about is the Waggaman acquisition gives us a lot of flexibility in terms of how we think about continuing to grow our own decarbonized ammonia platform base and different levers in terms of how to achieve that while having the same kind of S&D balance in the industry and not overwhelming kind of the marketplace.
    
    So I think we're in a really good position. I think North America is clearly the place where these projects will get built and should get built both because of the huge natural resource base, low access to low-cost natural gas, but also the ability to do carbon capture and sequestration and the incentive structures in the 45Q. So more to come, but I think there's a lot of vaporware announcements out there right now.

More on these clean energy initiatives:

I think a lot of the new demand that we're looking at for ammonia as a clean energy source is much more likely to be kind of longer term, contractually based with ratable offtake and a return profile that's attractive based on either the acquisition price of the asset or the build construction if it's new build. And so our expectation is that, we believe that we're the best operators of these kind of assets in the world. We operate in one of the lower-cost regions. There's incentive structures out there from a legislative perspective. And access to some great partners like we have with ExxonMobil and others to help us achieve blue ammonia.

And so from that perspective, we think that we can earn a really attractive rate of return on incremental capital that we're putting in the ground on these kind of projects. And it's likely to be much more kind of ratable and fixed rate of return than it is subject to some of the volatility in the fertilizer space.

And so we think that adding some of those layers of attractive fixed margin returns will be pretty additive to the overall valuation of the enterprise going forward. We'll continue to generate some good cash flow for us that we can deploy either against share repo or appropriate growth projects when we find opportunities to continue to generate those rates of return.

So we'll probably see us doing more of that kind of thing, particularly as this new demand source emerges.

Finally, the pace of share buybacks should come back strongly through the rest of the year, now that they have completed the recent Waggaman acquisition:

 The first quarter was heavily influenced by the fact that we were in pretty advanced conversations for most of that quarter, and therefore, we were blacked out from being able to do buybacks and then we were able to kind of jump in after the announcement went out the door and participate a little bit.

I think we feel very comfortable about the amount of cash generation that we expect through the balance of this year, plus a sizable amount of cash on hand even after we consummate the Waggaman purchase. And so we have a large share repurchase authorization in front of us that the Board just put in place. But one of the things that we have seen is despite having what -- from a historical standpoint is a very strong Q1, including very strong cash generation, share price volatility that seems to trade on all kinds of other factors and we're committed to taking advantage of those dips opportunistically in a way that really rewards our longer-term shareholders in a very substantial way.

And so what you'll probably see is us diving in deeper and harder on the dips and less so when we're trading relatively flatter. But I think taking over a year or a 2-year period, that should really disproportionately reward those that stay with us.

Admittedly, the next twelve months won’t match the previous twelve months of FCF or earnings. However, the elements are still in place for robust demand and pricing dynamics going out at least two years. Even as pricing has relatively normalized, the demand due to restoring food stocks should continue to be supportive of CF’s market position.

Catalyst

Continued recognition of the high FCF characteristics.

Realization of the market dichotomy that has left high FCF stocks at rare valuation levels.

Resumption of aggressive share repurchases.